BofA Rings Fannie

For the week, the Dow was slightly positive and the S&P500 slightly negative. Economically sensitive issues outperformed, with the Transports and Morgan Stanley Cyclical indices adding 1%. The Utilities and Morgan Stanley Consumer indices were unchanged. The broader market was its usual volatile self, but ended the week about flat. The small cap Russell 2000s slight advanced increased its year-to-date gain to 36%. The S&P400 Mid-cap index was unchanged. The highflying technology sector gave up a little air. For the week, the NASDAQ100 declined 1% and the Morgan Stanley High Tech index dipped 2%. The Semiconductors (up 61% y-d-t) and NASDAQ Telecommunications (up 56% y-t-d) indices were unchanged. The Street.com Internet index declined 1% (up 70% y-t-d). The Biotechs declined 4%. Financial stocks were resilient, with the Broker/Dealers posting a small gain (up 53% y-t-d) and the Banks advancing 1% (y-t-d up 25%). With bullion down $1.40, the resilient HUI gold stock index added about 1%.

From Dow Jones: "The junk bond market is winding down on a boom year characterized by more than $100 billion in supply, record inflows to mutual funds and returns around 20%. The Banc of America HY Broad Market Index is showing a return of 22.9% year-to-date as of Wednesday... Inflows to high-yield bonds funds totaled $23.3 billion so far this year, according to AMG..."

Nickel rose to a 14-year high this week. Copper prices rose to the highest level since October 2000. Aluminum jumped to the highest price since June 2001, while zinc rose to the highest since May 2001. Soybean prices are up 40% in less than three months, with the American Soybean Association reporting that Chinese bean imports were up 77% from the year earlier. Retreating energy prices led the CRB to a less than 1% decline for the week.

The dollar index gained less than 1%, although the Canadian dollar rose to its highest level against the greenback since January 1994.

Global Reflation Watch:

October 16 - Dow Jones (Mike Esterl): "The floodgates for emerging market debt officially have opened. Venezuela issued $470 million in international bonds Thursday, the same day that the Philippines put the finishing touches on a $1.05 billion overseas deal in what is shaping up as a very busy fourth quarter. Just Wednesday, Brazil sold $1.5 billion in foreign debt to investors, following in the wake of Mexico's $1 billion... China, meanwhile, has launched a roadshow to market an estimated $1.5 billion in overseas bonds, its first such placement in more than two years... Governments from Manila to Mexico City are moving quickly to take advantage of cheap financing that's being fueled in large part by loose monetary policy and rock-bottom interest rates in developed economies. Emerging market bonds are trading at a premium of less than 450 basis points over U.S. Treasurys, the narrowest spread in more than five years. Even before Thursday's placements, sovereign issuers had placed $46.14 billion in emerging market debt so far this year, up from $26.18 billion in the like 2002 period, according to Dealogic... Market participants say Bulgaria, Colombia, Panama, Peru and Turkey are among the long list of countries that could bring new deals to international capital markets before the end of December. Brazil, shut out from capital markets for most of 2002, could still issue some debt in yen or euros before the end of the year... Credit rating agencies, meanwhile, have been tripping over themselves in recent days to upgrade several major countries. Earlier Thursday, Standard & Poor's raised Turkey's junk-bond rating to B+ from B and Moody's upped China's investment-grade rating to A2 from A3... More than half of the EMBI Global is now investment grade, compared with about 10% in 1998, and investors reckon more upgrades are in store... According to Dealogic, emerging market corporates have issued $82.04 billion in debt so far this year - up from $63.72 billion in the like 2002 period and the biggest tally in the past five years."

October 15 - Bloomberg: "OAO Sberbank sold $1 billion of bonds, a record for a Russian lender, as investors return five years after the government's debt default pushed the country's banking industry close to collapse." "Brazil sold $1.5 billion of bonds, locking in its lowest-ever borrowing rates after a two-month rally in the nation's benchmark security, people familiar with the transaction said." October 16: "The Philippine government sold $1.05 billion of bonds overseas, double its target..." October 13: "Romania may attract more than $1.4 billion in foreign direct investment this year, the most since 1998, after its credit ratings were raised..." Singapore Power's (SP Powerassets) $1.6 billion offering was three times over-subscribed.

October 15 - Bloomberg: "Chile, the world's biggest supplier of copper, said exports of the metal rose 41 percent in September from a year earlier, after prices climbed."

October 15 - Bloomberg: " "The Chilean government sold 18.7 billion pesos ($28.9 million) of 20-year bonds, its first domestic sale in almost two decades, as part of a plan to fund a budget shortfall and pay debt... The Chilean central bank's lending rate is 2.75 percent, its lowest level since the bank began setting the rate in 1986."

October 16 - Bloomberg: "The Indian rupee posted its biggest one-day gain in five years after overseas portfolio investors brought in more money to buy local stocks on expectations economic growth may boost corporate earnings... Foreign investors have helped buoy the nation's foreign-currency reserves by more than $25 billion this year to $89.33 billion as the central bank bought dollars..."

India's September auto sales were up 17% y-o-y. The Indian rupee yesterday enjoyed its biggest one-day gain September Thai auto sales were up 23% y-o-y, as consumer confidence rose to a record level. European new car registrations were up 4.4% y-o-y during September, following August's 4.7% y-o-y decline. The Argentine Economic Minister yesterday doubled his estimate of 2003 economic growth to 7.0%. Sweden's unemployment rate dropped to 4.8%. The Bank of Greece increased its forecast for 2003 growth to 4.0% from 3.7%. Year-over-year global PC shipments were reported up 15.7%.

October 15 - Bloomberg: "China posted its smallest trade surplus in six months in September as imports rose to a record, bolstering the Chinese government's argument that the yuan's fixed exchange rate helps stimulate demand for overseas goods. China's trade surplus narrowed to $290 million, the smallest since March... Imports increased 40 percent from a year earlier to $41.7 billion, outpacing a 31 percent gain in exports... 'China's imports are growing faster than exports because of rising domestic demand,' said Xia Chun, an economist at China Merchants Securities in Shenzhen. 'Accelerating import growth should alleviate pressure on China to let the yuan appreciate.'"

October 16 - Bloomberg: "China's foreign-currency debt rating was raised one level by Moody's Investors Service, which cited the government's growing reserves of overseas currencies, second only to Japan. 'China's dynamic export performance has been reinforced by its continued ability to attract substantial amounts of foreign direct investment,' Moody's said. 'This has led to a large buildup in official foreign exchange reserves, even before the advent of speculative foreign currency inflows.' ...China's 6.8 percent dollar-denominated bond maturing in May 2011 was bid at a yield about 15 basis points more than similar-maturity U.S. Treasury."China's broad measure of money supply was up 20.7% y-o-y during September. Auto production was up 37% from September 2002, with steel production up 26%. Third quarter growth was reported at a stronger-than-expected 9.1%, up sharply from the second quarter's 6.7%. "China's January through September crude oil imports were up 29.8%, according to Business Daily, with Soybean imports up 130%..."

October 16 - PeoplesDaily: "China's industrial output grew by 16.3 per cent in September compared with a year ago to 370.4 billion yuan (US$44.6 billion), the National Bureau of Statistics said yesterday... The five sectors contributed 8.5 percentage points to September's industrial growth, the bureau said. The output of cars surged 69.7 per cent in September from a year earlier to 191,300 vehicles, while output of all kinds of vehicles rose a year-on-year 36.8 per cent to 427,600."

Domestic Inflation Watch:

October 13 - Bloomberg: "European Central Bank council member Ernst Welteke, (the president of Germany's Bundesbank) comments on the U.S. current account and budget deficits as well as on foreign exchange rates. 'The structural imbalances are growing. The U.S. needs the support of the world to bring about an orderly adjustment. Each day the U.S. needs $2 billion to finance its current account and the budget deficit... The growing imbalances cannot be eliminated only by exchange rate adjustments. A real change in policy is needed. The government and the citizens live beyond their means. Abrupt foreign exchange adjustments can push the world economy into a crisis.'"

October 13 - Bloomberg: "The Cincinnati City School District, the wealthiest of the eight urban districts in Ohio, plans to sell $480 million of bonds Wednesday to renovate or replace every school in the district. The bond sale, the largest ever for a local government in the 7th most populous U.S. state, will help pay to build 35 new schools and renovate 31 other facilities over the next 11 years." (This provides a good example of how easy money will find a home and be spent on one thing or another.)

October 14 - Bloomberg: "Lehman Brothers Holdings Inc. is offering as much as $10,000 to workers who refer a potential vice-president for employment at the company, the Financial Times said..."

October 14 - Bloomberg: " Manhattan apartment prices rose 6 percent to a record in the third quarter, as New Yorkers, buoyed by stock-market gains, purchased more luxury real estate. The average price increased to $916,959 from $864,860 in the second quarter, and the average price for luxury units jumped 14 percent to $3.46 million, according to a report by appraiser Miller Samuel Inc. and Douglas Elliman..."

Merrill Lynch today raised its estimate for third quarter GDP from 4% to 6%; Lehman Brothers from 5% to 6%; and Wells Fargo from 6.5% to 7.0%. This would put growth at the strongest pace since 1999. From Bloomberg: "Lehman and Merrill Lynch agreed that the expansion won't be strong enough to require the Federal Reserve to raise short-term rates anytime soon." It is worth noting that September Retail Sales were up 7.5% from September 2002, the strongest y-o-y gain since April 2000. Wal-Mart and other major retailers have recently reported sales above plan. September CPI increased 0.3%, the fourth straight month of price gains. Unemployment claims dropped to the lowest level since mid-February.

Industrial Production gained 0.4% during the month, led by a 6.6% increase in automobile production. This was the strongest gain in auto production since 1998.

The Manufacturing component jumped 0.7%, the strongest gain since April 2000.

New York Fed's October Manufacturing Activity index rose 15.35 points to 33.7, the highest reading in the 28 month life of the survey. The index is up from August's 9.98 and April's negative 20.2. New Orders jumped from September's 13.03 to 34.79. The Number of Employees jumped 11 points to 10.78.

The Philly Fed General Business Conditions index surged 13.4 points to 28.0, the strongest reading since July 1996. Expectations were for a reading of 16. New Orders surged almost 10 points to 29, the highest reading since September 1995. Shipment jumped 15.6 points to 28.8, the strongest reading since November 1999. The Employment index increased better than 10 points to a positive 5.5, the best reading since September 2000.

The National Association of Homebuilders October index jumped 4 points to 72 (versus expectations of 67), the strongest reading since November 1999. The index has surged 20 points over the past six months. The Present Sales index jumped 6 to 79. The S&P500 Homebuilding index is up 64% y-t-d.

September Housing Starts were reported today at a much-stronger-than-expected rate of 1.888 million units. This was the second-strongest pace since April 1986 (according to Bloomberg), only slightly behind July's record of 1.89 million. Starts were up 4.3% y-o-y. Building Permits were also stronger-than-expected, with single-family Permits up 7.4% y-o-y. Single-Family Homes Under Construction were up 11% y-o-y. Year-to-date, Permits are running up 13.3% in the West, 5.1% in the South, 4.5% in the Midwest, and down 1.2% in the Northeast.

There were 33,429 bankruptcy filings last week, with y-t-d filings running up 7.3%.

"Third Quarter Production Totals" from Countrywide Financial: "Loan fundings for the month rose 31 percent over the prior year to $33 billion. Total fundings for the third quarter of $126 billion were up 98 percent over the third quarter of 2002. Total volume year-to-date set a new record at $359 billion and was $107 billion more than total production for calendar 2002. Monthly purchase fundings rose 64 percent over September 2002... Adjustable-rate loans accounted for 30 percent of total production in September and totaled $28 billion for the third quarter... Home equity fundings for the third quarter reached $5.4 billion, 23% higher than the second quarter of 2003 and up 77 percent from the third quarter of 2002. Subprime loan production totaled $5.5 billion for the quarter, up 30 percent over the second quarter of 2003, and 131 percent greater than the third quarter of 2002... Total assets at Countrywide Bank...rose to $16 billion, an increase of 8 percent from last month and 262 percent more than September 2002."

Curiously, mortgage application volume dropped sharply last week. Refi applications were down 18.5% to the lowest level in six weeks. More importantly, Purchase applications dropped 18.5% to the lowest level since April. Year-over-year dollar volume was up 11.2%. I will assume at this point that it is a one-week aberration in Purchase applications but will follow developments closely.

October 16 - The Wall Street Journal (Aaron Lucchetti): "Standard & Poor's dropped its credit rating of Pittsburgh's municipal debt by five notches to junk status, underscoring the financial difficulties of many cities. The decision by S&P, announced yesterday, affects about $879 million of Pittsburgh debt outstanding, all of which is insured, meaning any losses from a possible default would be born by insurance firms instead of investors. But the action nevertheless made investors nervous as it was one of the sharpest downgrades of tax-exempt municipal debt since California's Orange County filed for bankruptcy protection in 1994... The western Pennsylvania city of 330,000 has an aging population that isn't growing, rising health-care costs and an underfunded pension plan."

From Credit insurer Ambac: "Net premiums written in the third quarter of 2003 of $262.9 million were 47% higher than net premiums written of $178.3 million in the same period of 2002... International continues to be our fastest growing market, as net earned premium and other credit enhancement fees grew 44% during the quarter. Earned premiums grew 34% in the structured finance segment." Public Finance Net Premiums Earned were up 22% y-o-y. Net Claims in Force (NCF) increased $13.7 billion during the quarter to $608.5 billion (9.2% annualized growth). NCF were up $83.9 billion y-o-y, or 16%. Ambac ended the quarter with Statutory Capital of $4.2 billion and Total Claims Paying Resources of $9.0 billion.

Mortgage insurer MGIC disappointed the Street, as earnings declined 30% y-o-y to $105.1 million. Losses Incurred surged 28% to $221 million and were more than double Q3 2002. Total Insured Loans declined 5% y-o-y to 1.57 million. The mortgage insurers are one of the few groups within the financial sector not enjoying significant growth. Therefore, their delinquency and loss data are much more telling than most. MGIC's Total Loans Delinquent were up 27% y-o-y to 85,039. The delinquency rate jumped 46 basis points during the quarter to 5.41%, and was up 137 basis points y-o-y. Subprime delinquency surged 69 basis points during the quarter to 13.73%, with a y-o-y increase of 135 basis points. MGIC's results do not bode well for the day air begins to come out of the Mortgage Finance Bubble.

Credit Card behemoth MBNA Financial saw Net Income surge 66% to $658.8 million. Total Assets expanded at an 11% rate during the quarter to $58.7 billion. Total Assets were up 16% y-o-y. Total Managed Loans increased at an 8% rate during the quarter to $112.8 billion and were up 10% y-o-y. Managed delinquencies increased a modest 2 basis points during the quarter to 4.48% (down 31 basis points y-o-y), while Credit Losses dipped 22 basis points (but were up 29 basis points from Q3 2002). "During the first nine months of 2003, the Corporation added 8.0 million new accounts, with 2.7 million new accounts added in the quarter. The characteristics of new cardholders are consistent with the quality of the Corporations existing cardholders... the typical new cardholder has more than a $70,000 annual household income, has been employed for more than 11 years, owns a home, and has a 18-year history of paying bills promptly."

"Merrill Lynch...reported net earnings of $1.04 billion for the third quarter of 2003, up 50% from $693 million in the third quarter of 2002... "Principal Transactions revenues increased 87% from the 2002 third quarter, to $705 million, due primarily to increased debt and equity market trading revenues... Underwriting revenues were $545 million, 66% higher than the 2002 third quarter, due primarily to increased equity underwriting revenues... Other revenues were $300 million, up $135 million from the 2002 third quarter due to increased revenues from investment and sales of mortgages."

Bank America reported third quarter earnings of a record $2.92 billion, up 31% from the Q3 2002. "Mortgage banking income increased 203 percent to $666 million. Card income increased 16 percent to $794 million. Trading account profits increased 146 percent to $175 million." Average Assets were up 6% annualized during the quarter and 17% y-o-y to $785.7 billion. Average Commercial Loans declined at an annualized rate of 18% during the quarter and were down 10% y-o-y to $132.9 billion. Conversely, Averaged Residential Mortgages expanded at a 34% annualized rate during the quarter and were up 25% y-o-y to $130.9 billion. Total Average Consumer Loans increased at a 25% rate during the quarter and were up 17% y-o-y to $224.4 billion. Curiously, BofA ended the quarter with Total Assets of $737.1 billion, down $32.1 billion. Securities Available for Sale dropped $49.6 billion during the quarter. BofA must have called Fannie's trading desk - "Buyer of First and Last Resort" - late in the quarter to pare down its bloated balance sheet.

Wall Street may celebrate, but Fannie's third quarter is an alarming development for systemic stability. Fannie's Total Assets surged an unprecedented $94.3 billion to $1.018 Trillion. It is simply difficult to comprehend a trillion dollar balance sheet expanding at a 41% annualized rate. For perspective, Fannie ended 1990 with Total Assets of $133 billion. During September, Fannie's retained Mortgage Portfolio surged an unprecedented $54.0 billion (107% annualized growth!) to $917.1 billion. "Total business volume rose to a record $145.6 billion in September." Wow... Over the past three months, Fannie's (net) Mortgage portfolio has increased $104.7 billion, or 52% annualized. Year-over-year, Total Assets were up $180 billion, or 22%. Fannie's Book of Business (retained mortgages and guaranteed MBS in the marketplace) surged $386 billion, or 22% annualized, over the past twelve months to $2.128 Trillion (supported by "Total Capital" of $33.5 billion). The Book of Business is up $624.7 billion, or 42%, over 24 months. Fannie repurchased 5.5 million shares of stock during the quarter.

Fannie Liquefies the World:

Having carefully watched the GSEs for more than a decade, nothing should really surprise me. I remember back to the year 1994. The Fed was raising rates; the heavily-exposed leveraged speculating community was reeling; and the fledgling interest rate derivatives market was in tatters. Fannie Mae's, at the time, unprecedented 12-month $55 billion balance sheet expansion played an instrumental role in sustaining system liquidity, as the Fed took away (for a little while) the punch bowl. During the infamous fourth quarter of 1998 - with the market nearly "seizing up" during the LTCM debacle - Fannie expanded assets by a then record $29.9 billion. For all of 1998, Fannie expanded its balance sheet by $93 billion. This expansion was almost 70% greater than the previous record set during 1994.

Well, Fannie increased its balance sheet during the third quarter by more than the entire year of 1998. This thing has really gotten out of control. For one, Fed funds are at 1% with not even a hint of a future tightening. Second, apparently we are to believe that things are hunky-dory with both the leveraged speculator and interest rate derivative communities. So why $94 billion? Ominous, ominous, ominous...

Well, I don't think all is well. Rather, the scope of liquidity injections today necessary to keep the U.S. financial and economic Bubbles levitated is now expanding exponentially. The amount of mortgage Credit expansion to keep the Great Mortgage Finance Bubble inflated is expanding exponentially. To this point, the GSEs and the U.S. financial sector have been able to keep up. But things are clearly getting dicey.

For some time, that U.S. bond market has operated with the comfort that the U.S. economy was structurally impaired. Not even gross financial excess would sufficiently stimulate a broad-based recovery with sufficient vigor to unnerve the cowardly Fed. Moreover, the premise has been that the global economy and financial system were exceptionally distorted and unbalanced. Virtually any amount of U.S. generated liquidity flowing globally would be immediately recycled back to the U.S. financial markets. It was simply difficult to envision a scenario where global liquidity and Credit availability would be sufficient to stimulate a synchronized global recovery. Well, times have changed dramatically. Such a scenario is today not the least bit far-fetched.

While the U.S. Credit system remains on historic overdrive, Credit systems all over the world are getting in gear. This is clearly a positive for non-dollar assets (real and financial). Going forward, continued U.S. Credit excess will be increasingly destabilizing and risky for U.S. financial assets. The dollar remains extraordinarily vulnerable, with the massive current account deficit combining with the largest "outbound" speculative flows in quite some time (ever?). Rising bond yields did underpin a bit of a respite for the dollar bear market this week. As we have witnessed over the past few months, higher U.S. bond yields do tend to support the dollar. But how high can U.S. yields go without inciting other problems?

The bond market is going to be fascinating. Can the Fed continue to talk down long-term interest-rates, enticing the leveraged players with 1% borrowing costs and a steep yield curve (for as far as the eye can see)? Or does the bond market look at fundamental developments and wake up in a cold sweat one of these mornings? Interest rate markets flirted with dislocation back in July, and there should be no doubt that unprecedented leverage coupled with the historic derivatives scheme creates acute fragility in the event of any meaningful move higher in rates.

But it is becoming conspicuously clear that rising bond yields are necessary to temper rampant Credit excess and support the acutely vulnerable dollar. I doubt the Fed or the markets perceived that it could get to this point so quickly. The Fed has until now believed that artificially low interest rates and a weakening dollar posed little serious risk. They underappreciated the rate-induced massive Credit creation (dollar devaluation), the degree of liquidity-induced financial market excess/speculation, and the waning private overseas demand for U.S. assets. It is now becoming clear that the current rate environment is perpetuating the destabilizing Mortgage Finance Bubble and stoking over-liquefication at home and abroad (not to mention over consumption!). And we now know that the U.S. system survived its July interest rate scare because of Fannie's incredible liquidity maneuvers and the incredible foreign central bank dollar purchases. And, all the while, the resulting flood of liquidity drives rampant speculation throughout global financial markets. These desperate measures are not sustainable.

I just can't shake the notion that these ballooning GSE and foreign central bank balance sheets - and resulting speculative melee - portend a rather inhospitable financial environment on the not too distant horizon.

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Wednesday evening I had the privilege of speaking to a group of energized MBA students at Indiana University. What a treat!! Special thanks to Professor Robert "Buck" Klemkosky for the invitation, as well as for his wonderful hospitality. He's doing one heck of an outstanding job at Indiana, especially heading up his impressive Investment Management Academy. I could not have been more impressed with the quality of students, and I have never been involved in such a rousing Q&A session. The level of knowledge, enthusiasm and intellectual curiosity was truly inspiring.

For those that might be interested, I have posted my presentation:

I can't tell you how good it feels to be back to IU (Indiana University). What a beautiful campus, absolutely fantastic facilities and great people. And it is exciting to see that IU retains its reputation as one of the premier business schools in the country. Congratulations! I have such fond memories of my experience here at Indiana, both academically and socially. I certainly appreciate the quality of education I received and believe I was well-prepared for my investment career. But I also left Bloomington with a "healthy" perspective, valuing a hard work ethic and integrity, while harboring no delusions of grandeur.

I remember sitting there where you're sitting and listening to a speaker from one of the major Wall Street firms. I don't recall much of what was said, except for the part where he discussed the attributes of his successful colleagues. He said there was something "special" about each one of them - some had mastered several languages; others had unusual interests and multiple degrees; another had important family connections overseas. I sat there thinking, "There's nothing special about me; I'm just a small town kid from Oregon that doesn't even speak English very well. I doubt I'm cut out for success on Wall Street." Well, from my 14 years in the industry I will tell you that the special attributes of my successful colleagues are hard work ethic, integrity, an intense passion for their work and perseverance.

For this evening's talk, I'll touch on my background, some comments about managing money on the short side, my experience with market cycles and hopefully provide some insights into the current extraordinary environment.

First, I'll touch on my background. Prior to my arrival to Bloomington, a spent two years as a PriceWaterhouse CPA and less than two years at Toyota's U.S. headquarters in Southern California. It was during the tumultuous year of 1987 as a member of the debt management team at Toyota that I developed a passion for the markets. Since leaving IU, I have accumulated 14 years of investment experience. I have worked as a trader, analyst, and portfolio manager on the short-side. I am a professional bear and, curiously, there are not many of us around.

For the past five years I have worked as Financial Market Strategist for David Tice & Associates in Dallas. We currently have about $1 billion under management split between our two mutual funds. We manage the Prudent Bear Fund - where we short stocks, hold put options, and also take some long positions, mainly gold stocks and natural resource companies. It is our mandate to make money in declining markets, offering a hedging vehicle to offset long-side risk. We opened our Prudent Global Income Fund back in 2000 to profit from what we believed was an imminent decline in the dollar. We own high-quality foreign government bonds and a limited position in gold stocks.

In the evenings, I also write a column for our website I titled the Credit Bubble Bulletin. I began writing my articles because I saw a whole fascinating world of market activity and analysis that was being completely ignored by the mainstream press and Wall Street commentators. For some reason, the entire topic of Credit and its instrumental influence on the financial system and economy is largely disregarded by the media and, apparently, by the Federal Reserve as well. I am fiercely independent and unconventional. Fortunately, the Internet today affords independent and creative thinkers opportunities unlike any in history. It is a very exciting time to be "unconventional." We now have an outlet, and there is a hungry audience for sound analysis.

Let's spend a few minutes on the topic, "Managing Money on the Short-Side." First of all, it is definitely not the opposite of investing on the long-side. Importantly, the risk dynamics are very different and much more challenging. Only on the short-side can our fundamental analysis be 100% correct and we have 100% conviction, yet we risk losing 100% of our money. Think about that for a second. On the long-side, we can obviously suffer losses when a stock declines in price. But if we are right on the analysis and willing to sit tight, we will eventually recover unrealized losses and make money. The key point is that when a long position goes against us, our money at risk is also reduced.

The short-side is a completely different story. We have unlimited risk when our positions move against us, so we must reduce our exposure or risk losing everything. Coming into 2003, there were many that believed Amazon.com was overvalued and a good short. The stock began the year with 50 million shares sold short. The stock is up 200% year-to-date. Intel began the year with 63 million shares short, and it has doubled in price.

From a mutual fund portfolio management perspective, things become only more interesting: Let's say we have $100 million under management on the long side and are fully invested. Now the market moves against us 10% - which in this volatile marketplace can occur quickly and unexpectedly. So our $10 million loss reduced fund assets to $90 million, with the market value of our investments also down to $90 million - so we remain fully invested at 100%.

Now let's see how this works on the short-side. We begin again fully invested with $100 million of fund assets and $100 million of short positions. When the market moves against us 10% and we're short, what has happened to fund assets and the market value of our positions? Well, fund assets have been reduced by the $10 million loss to $90 million. But what about our short position? It has increased $10 million to $110 million. So our exposure has suddenly increased to 122% - positions of $110 million divided by $90 million of shareholder fund assets. If we sit tight and the market moves another 10% against us, our equity then drops to $79 million while our short positions grow to $121 million - our short exposure explodes to 153%. Think about these dynamics in an environment where NASDAQ has jumped more than 40%. And these calculations don't even factor in fund outflows that can be significant when the market is moving against us. The point being, on the short-side we must be constantly fixated on the general market environment, risk management and mitigation, and liquidity. When things are going against us, we must put our fundamental views and analyses to the side and quickly get our risk under control.

The very nature of our business demands that we incorporate both a disciplined top-down and bottoms-up approach. We need to laboriously analyze the macro financial and economic environment, as well as remaining focused on diligent traditional micro company research. The risk dynamics are such that we are not true investors as much as we are disciplined professional speculators. As such, there is wisdom to garner from the old Gambler's Song: "You've got to know when to hold them, know when to fold them; know when to walk away and when to run." To succeed over the long run, we must be accomplished at micro research, macro analysis, and speculative market dynamics. It's one heck of an exciting challenge.

I can say today that I truly love my work and feel blessed for the opportunity to make a living doing something that I find so stimulating and personally satisfying. I wake up excited every morning. I jump up and go directly to my trusty laptop to get a handle on how overseas markets performed and to read the latest news from more than a dozen sources. At night, I take one final look at global markets before I go to bed.

For many in the industry, the markets are truly an obsession. I believe Ryan (Ryan Bend, our talented IU summer intern) got a feel for this dynamic during his summer with us. And when he would take his yellow highlight pen to the Wall Street Journal in the morning and stay late into the evening discussing the markets, I could see the inkling of obsession in his eyes. But there's a doubled-edged sword at work here.

Today, I enjoy a wonderful obsession. But it hasn't always been this way - far from it.

In the past, there were too many days when I can honestly say I would have preferred to be employed by the government. And I am completely serious about this: It got to the point where I yearned for an 8 to 5 job where I could leave work at the office - anything but to have my livelihood and happiness dictated by the stock market.

There is a thin line between love and hate, passion and compulsion, healthy and unhealthy obsession. Understand that the market does whatever it wants to do, when it wants to do it. And it doesn't care about how you are positioned, that you have a family, that you would like to take some vacation, or that you are suffering from insomnia. The market doesn't care how smart you are or how hard you work. Moreover, the market has occasion to move in a manner to cause the most grief to the largest number of participants, and it will do this precisely when the crowd least expects it. It becomes imperative, then, to be well-prepared mentally, financially, physically, and otherwise for tough weeks, months, quarters and even years.

I began working for a hedge fund dedicated to the short-side back in 1990.

Back then, there were thought to be perhaps a couple hundred hedge funds with $40 to $50 billion under management. Today, there more than 6,000 with assets estimated to be approaching $700 billion. Positions have ballooned to the unfathomable Trillions in what has regressed to little more than financial anarchy.

Last fall, when things looked especially gloomy, the Wall Street Journal ran a piece that brought back bad memories. The article told the story of a very tough year for a fledgling hedge fund manager, his wife and family. They were exasperated and didn't know how much longer they could hold out financially or emotionally. Well, the harsh reality is that the market environment can turn hostile at any time. It can be abrupt, untimely, and market hostilities can lead to quite difficult years. Think how the Japanese have struggled in a protracted bear market lasting more than a decade. As a professional bear, the nineties were tough for me and basically wiped out most of the short-selling community.

I think back to 1990 - my first year in the industry. You should all expect a challenging climb up the learning curve, even if the market is going your way. We were up better than 60% during the 3rd quarter of 1990, and at one point had more than doubled our investors' money. I used to daydream about what it was going to be like to be wealthy. Going into 1991, we were turning away investors. We had it all figured out, or so we thought. The economy was going into recession, the banking system was a disaster, and all this made it clear that we were going to start making some serious money. We were over-confident, arrogant, and complacent bears facing a desperate Federal Reserve.

The Fed proceeded to collapse interest rates, flood the markets with liquidity, and "reinflate" the system. Our Genius Hats were replaced with Dunce Caps. I can't tell you how humbling that was. Recalling the experience, 1991 was an extremely tough year; 1992 was excruciating; 1993 was a nightmare; 1994 provided hope and disappointment but mostly exhaustion; 1995 was an unmitigated disaster; and 1996 we finally closed the fund. I became an unemployed professional bear in a bull's world. I often refer to the 1990s as my lost decade, although it was one hell of an invaluable learning experience.

Our fund failed; I failed. In this industry, failure is an especially lonely existence. When things are going well you have lots of friends and opportunities. But when performance sours, assets shrink, and the commission dollars stop flowing, the phone quits ringing. Dealing with failure is something very foreign to most in an industry comprised of individuals tending to have been successful with most things during their lives. Let me tell you, it feels like your entire world has been turned upside down.

But going through such an experience does provide endless hours - and too many sleepless nights - to think; to contemplate mistakes made, what went wrong, and how things can be done better. I firmly believe that to be a truly outstanding money manager, you've got to experience failure. The bottom line is that you don't learn nearly as much when you are making money and everyone is telling you how smart you are. You certainly don't focus on risk and what can go wrong. I do now.

Back in 1996, I was forced to start again from ground zero. Looking back, my most valuable asset was my integrity. With this I could look in the mirror, roll up my sleeves, and get to work. If I could emphasize one point today - one thing I hope will stick with you and find a home in your consciousness - I would say nurture, safeguard, covet your Integrity. On the radio a few weeks back I heard an interesting "thought of the day." It went something like this: "We should be focused more on our Integrity and less on our reputations." The more I thought about it, the more I really appreciated this perspective. No matter what the circumstances or enticing rewards, never jeopardize your Integrity. You're going to need it, and if you lose your integrity it will be very difficult to get it back.

For a few minutes I would like to discuss some administrative details - or what we can call, "Learning From doug's Mistakes." First of all, I took one week of vacation in almost 7 years working for the hedge fund. It was self-defeating. I simply refused to admit to myself that I was burned out and needed some time off.

But you must be prepared for long, intense hours and, at times, almost unbearable stress. I battled with intense stress for years. At times I would feel poorly - I would get dizzy, lightheaded, and was often listless. I think it was 1992 that I developed high blood pressure. My physician prescribed beta blocker medication. But I also gave up my favorite fast-food Mexican, started drinking fewer beers and worked to get more rest during the weekends. I also commenced a disciplined fitness program and became best friends with my bike. We remain best friends today. I began eating salads and exercising every day. In about four months my blood pressure was back to normal, I felt much better, and I've been of the medication ever since. I can't stress enough the importance of taking good care of yourself - make a healthy diet and a regular exercise program an integral part of your daily routine. You're going to be very busy, but make the time and effort, and healthy living will pay dividends in the short and long-term.

I also want to mention the importance of generally having the right mindset. In the past I would obsess with how much money I could make. Whether I recognized it at the time or not, making money was the priority - my fixation. When this approached failed, I made a conscious decision to place my analysis first - my new obsession - and let the financial part take care of itself. This change in mindset has made a world of difference. My analysis is better and I'm much happier. I feel a sense of inner satisfaction that my priorities are in order.

Let's now spend a few minutes with the issue of working these days in the financial services industry. There is, of course, intense regulatory and public scrutiny. I think for most work is more burdensome and less fun today than it was in the past. These are extraordinarily uncertain and unsettled times. A lot of things are outside of our control. I'll briefly highlight the experience of a long-time friend of mine. This individual is one of the hardest working, honest, and brightest people I know. He worked his tail off and became partner at his firm. The only problem - although a very serious one - was that the firm was Arthur Anderson.Don't have the false illusion that things are always going to be fair.

And expect market cycles to play a significant role in our lives - financially as well as emotionally. Try to temper your excitement and pocketbooks when things are going well, and keep perspective when things look bleak.

Recognize also that market cycles affect hiring patterns. Wall Street is expected to make a record $22 billion this year and the financial services industry is in the midst of a major hiring boom. The reality is that you will likely be hired by the hot, expanding groups in the hot, expanding sectors, by the hot and expanding companies. The odds of longevity with your initial positions won't necessarily be on your side. Don't get carried away extrapolating initial success and, if things go sour, try not to take it personally. Good or bad luck may play a major role in your early careers. Expect to ride the emotional and financial roller-coaster of up and down market cycles. Stick to your "knitting" and don't chase the hot groups. Find an area that suits your strengths, interests and temperament, then go out and strive to master it.

Endeavor to be prepared to persevere through the difficult periods. Save your money and diversify your assets. There is a natural tendency to put your personal eggs in the same basket where you have your professional expertise. Be mindful, however, of the risk that a changing cycle could turn both your job and your financial security upside down. And, importantly, keep your debts to a minimum. Excessive borrowings limit your flexibility and can lead to extraneous stress.

I would now like to humbly offer some professional advice: Always Question the Consensus - Second-Guess the Mainstream Opinion. It is fascinating to watch how often the consensus view is just flat out wrong. Yet there are powerful forces that attract most analysts to be part of the mainstream. After all, it is safe professionally to be part of the consensus; everyone can be wrong together. Conversely, it is risky to be outside conventional thinking. But Analytical Integrity demands that we be willing to accept this risk.

Why is the consensus so often wrong? Well, it revolves around a flawed analytical framework, adherence to ideology and the resulting bias, and an inherently optimistic bias. Most of us would like to believe that things are splendid and, besides, bullishness is good for business. In the late nineties it was the New Era, New Paradigms, The Technology Revolution and Miracle Economies. Today it's the Productivity Revolution and the Triumph over Inflation. The fact of the matter is that the consensus will concoct appealing and persuasive explanations and theories for rising stock and bond prices, as well as inflating home and asset prices. Bullish "analysis" will follow bull markets, with little concern for whether it is sound or not. The history of markets and economics is an endless tale of seriously flawed consensus views.

Strive to be Independent - Be Willing to Take Analytical Risk. But to do this you must have your "house in order." Do your homework; master your area. In addition, manage your personal affairs conservatively and keep your professional record spotless.

Be Committed to Diligent Observation. Dive into detail and try to avoid being captivated by the aggregates. The "mainstream" adores the aggregates. Today's economy provides a good case in point. We now enjoy trumpeted GDP acceleration, but the devil is in the detail. Growth is unusually unbalanced and unsound. Government spending is surging while the manufacturing sector and productive investment languish.

Also, regularly read the Financial Times and the foreign press to get a non-U.S.-centric perspective. As you appreciate, the Internet is a tremendous tool. And if you have access to a Bloomberg, become an expert using it. And, importantly, plan on working harder and having more perseverance than the Ivy Leaguers.

And analytically, "Follow the Money" or more specifically, "Follow Credit and Financial Flows." Today's Credit and speculative Bubbles - or so-called New Paradigms or "Miracles" - will be tomorrow's busts. We've seen it repeatedly in more than a decade of recurring booms and busts. During the late-eighties it was Japan and U.S. coastal real estate. The early nineties saw Bubbles in Mexico and the U.S. bond market. In the mid-nineties, it was South East Asia, Russia, and Argentina. And the late nineties Bubble dynamics overwhelmed Technology, NASDAQ, Corporate debt and "King Dollar." Current Bubbles include the hedge fund community, leveraged bond speculation, derivatives, Credit insurance and the entire arena of mortgage finance. The Bubbles just keep getting bigger and increasingly dangerous.

And, last but not least, never forget who you work for. Your investors come first - revere fiduciary responsibility.

I will borrow the title from an excellent book (by Perry Mehrling) for our next topic: "The Money Interests and the Public Interest." In your career you will have responsibilities to your firms, your clients, investors, and shareholders. But you also have an important obligation to society. It's not Wall Street's Financial System. Yet Never Before has Wall Street Enjoyed Such a Commanding Influence Over the Financial System and Economy. Power corrupts and corruption leads to backlash and dislocation.

There is this notion that financial operators, all acting in their own individual self interests somehow - through an alchemy produced by some "invisible" hand - create a financial system that operates in society's best interest as well. I believe this is dangerous and opportunistic dogma. Adam Smith's recognition of the wonders of free market trade in economic goods just does not apply to financial excess. Rather, I would argue that a stable and controlled Credit system is a fundamental requirement of a sound Capitalistic system. Importantly, Credit and speculative excess distort the free-market pricing mechanism. Left unchecked, there is a strong inflationary bias that will increasingly distort, corrupt and impair the system over time.

And now some brief thoughts regarding the current Extraordinary Environment. For the first time in history, we operate in a global financial system dictated by unfettered money and Credit creation. There is absolutely no control over the quantity or quality of monetary expansion. There's no gold standard, no dollar standard, No Standards. Things have regressed to "Wildcat Finance" on an unprecedented global scale.

The U.S. is in the midst of an historic Credit Bubble that is coveted by a self-serving Wall Street and nurtured by our incompetent Federal Reserve. It has gotten so out of control that the Fed's role is simply to sustain an unsustainable Bubble and hope to avoid a debt collapse. This is disastrous central banking. I fear that Wall Street is self-destructing; I fear that our Credit system is self-destructing. And these dynamics are going to have a major influence on our careers and lives, so I urge independent study.

The great American economist Hyman Minsky was known - and harshly criticized - for arguing that Capitalism is "flawed." Much of his analysis evolved from his brilliant understanding of the "roaring twenties" and the subsequent financial collapse and Great Depression. Liberally paraphrasing Minsky, there are miraculous attributes of risk-taking and profit-seeking in the real economy that interplay with the financial system's tenacity for achieving both earnings gains and expansion. But, when left unchecked, there is a propensity for over-expansion and increasingly risky behavior. The system can run out of control, which spawns financial fragility, economic distortions, and eventual self-destruction.

Minsky's powerful analysis is quite pertinent today. But I would argue that instead of "flawed," Capitalism is, instead, inherently vulnerable. I will try out my Eyeball Analogy: One could argue that there is a serious "flaw" in the design of our eyeballs - something with such a critical function shouldn't be so soft, delicate, and left unprotected to the elements. Yet it is the very nature of this organ's amazing functionality and capabilities that create its vulnerability. Your eyeball and Capitalism are not flawed, but they are - by their very nature - Inherently Vulnerable.

So, just as we wear sunglasses in the bright sun, or would don safety glasses in a metal shop, we must recognize our system's vulnerabilities and be determined to take preventative measures.

We are today in the midst of historic financial and economic Bubbles and, regrettably, there is absolutely nothing at this point we can do about it. We merrily ignored our system's vulnerabilities. I believe we are in a very late stage, so I spend a lot of time pondering the post-Bubble environment. There will undoubtedly be a powerful and deserved backlash against Wall Street. But with upheaval and dislocation springs opportunity. Yet my greater fear is the growing global revulsion to free markets and Capitalism generally, revulsion I expect to later take hold here at home.

So I would like to leave you this evening with a thought for the future: As financial professionals, it may be up to us to defend free markets and Capitalism. I believe that to be effective proponents will require forthright admission that serious mistakes and impropriates were committed - that things ran terribly amuck. If blame is rightly placed with a renegade financial sector and derelict central banking, then perhaps some of the disdain for free markets and Capitalism can be deflected. As credible defenders of the marketplace, we will need to be proponents of a disciplined, stable and controlled Credit system. Thank you very much.

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